Credit: Still shines beyond intervention
Credit markets learning to stand on their own two feet. We had a bullish stance on credit at the turn of 2H20, believing that the unprecedented amount of stimulus by the US Federal Reserve – most significantly the unconventional policy tool of corporate credit purchases – would see credit markets lead the recovery (please refer to “Global Credit 3Q20: Leading the recovery”, 6 July 2020). As it stands, things have turned out even better than expected.
While credit markets have performed well so far in 3Q20, it is curious that the gains were registered despite the Fed actually cutting back on credit purchases in the background, declining from an average of more than USD1b per week between May and July to a total of just USD580m between August and 9 September. This is indicative that the market is moving beyond the crutches of policy support and taking baby steps towards full normalisation.
Figure 1: The US Fed – unlike the ECB – tapered credit purchases over the summer
Source: Federal Reserve Board, ECB, Bloomberg, DBS
Declining purchases came amid a seasonal liquidity lull. What is also notable is that the pullback in Fed purchases occurred in an August month that seasonally sees a decline in bond market liquidity – still the market continued to function unimpaired. This inspires confidence that market factors are increasingly driving credit performance, factors that go beyond just the flow of bond-buying from the central bank (although the facilities remain in place as a backstop, extended by the Fed from end-September at least till end-December).
Figure 2: The Fed was hardly called upon to bridge the August liquidity lull
Source: Bloomberg, DBS
The market has voted in favour of EM risk through the flow picture. If there was still any doubt in the lower-for-longer rates narrative, it was all but erased following the September Federal Open Market Committee (FOMC) meeting, where the Committee made a steadfast commitment to see rates at the zero-bound for the next three years – at the minimum. So even if the Fed were to conclude explicit purchases of bonds via its credit facilities, credit remains in favour as the market has gone ahead in expectation of a long era of low rates to reach for yield, through a larger risk exposure in Emerging Markets (EM) and High Yield (HY) credit.
It was likely such incremental exposure that supported credit performance, partially compensating for the pullback in Fed purchases over July-August, as evidenced by the flow picture.
Figure 3: Investors saw an inclination towards EM risk in the hunt for yield
Source: EPFR Global, DBS
Performance divergence shows clearer relative preferences. The necessary corollary of the decline in Fed purchases is the pullback in excess credit liquidity and emergence of relative value. In this regard, US credit – though still capturing positive returns – had not fared as well compared to the rest of the world. We see the early price action as supportive of our two recent views, namely that: (a) European HY would outperform the US within Developed Markets (DM) (please refer to “Credit: Europe over US in DM HY”, 7 August 2020), and (b) HY would be preferred over Investment Grade (IG) (please refer to “Credit: New Fed framework favours HY over IG”, 31 August 2020) at the margin following the change in the Fed’s framework concerning inflation targeting.
Figure 4: Performance showed greater divergence following the Fed credit taper
Source: Bloomberg, DBS
Investors should stay engaged with credit, with or without the Fed’s direct intervention. The scarcity of yield will become increasingly glaring as the Fed floors rates at the zero bound for years to come, and credit spreads are likely to grind lower as demand for such income assets will stay high for a lack of alternatives.
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